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Four warning signs may make the Fed change its aggressive rate hike plan |

Strategists are looking for important indicators other than inflation that could make the Federal Reserve (Fed) change its aggressive rate hike plan Sexual shrinkage, foreign exchange market turmoil deepened.

1. Widening credit spreads

The average U.S. investment-grade corporate bond yield, compared to the risk-free U.S. Treasury yield, is the so-called credit spread. Credit spreads have jumped 70% over the past year, and corporate borrowing costs have risen rapidly, largely because recent U.S. inflation rates have been higher than market expectations.

Although the current spread has slipped from its peak of 160 basis points in July, the cumulative gain is still large, underscoring the growing pressure on credit markets amid monetary tightening.

Chang Wei Liang, chief strategist at DBS Group Holdings, said: “Investment-grade credit spreads are by far the most important indicator because of the high proportion of investment-grade government bonds. If investment-grade credit spreads widen above 250 basis points, close to The peak during the pandemic could prompt the Fed to fine-tune its policy guidance.”

The average option-adjusted spread (OAS) of the Bloomberg U.S. Aggregate Corporate Bond Index. Source: Bloomberg

U.S. financial conditions have tightened in mid-August to levels not seen so far in March 2020 as borrowing costs rose and share prices fell, Goldman Sachs compiled a gauge of credit spreads, stock prices, interest rates and exchange rates. Fed Chairman Powell said earlier this year that financial conditions are the Fed’s indicator of the effectiveness of policy.

2. Increased default risk

Another indicator is the cost of contracts to insure against default on corporate bonds. Looking at the “Markit CDX North American Investment Grade Index Spread,” a measure of a basket of investment-grade bonds, credit default swaps (CDS), has doubled since the beginning of this year to 98 basis points, which is quite close to the peak of 102 basis points seen in June this year.

Default risk is closely related to the appreciation of the dollar.

The Markit CDX North American Investment Grade Index (black) and the Bloomberg Dollar Spot Index (red) have been trending this year. Source: Bloomberg
3. Bond market liquidity shrinks

Liquidity in the U.S. Treasury market is shrinking. Bloomberg’s metrics tracking U.S. Treasury liquidity are at their worst since the start of the pandemic in early 2020.

The depth of the U.S. 10-year Treasury bond market tracked by JPMorgan has also fallen to the lows seen in March 2020. Even the most liquid government bonds at the time were difficult to match.

Bloomberg U.S. Government Securities Liquidity Indicator. Source: Bloomberg
Bloomberg U.S. Government Securities Liquidity Indicator. Source: Bloomberg

Thin liquidity in the bond market will add to the pressure on the Fed to shrink its balance sheet. The Fed currently lets $95 billion in Treasury bonds and mortgage-backed securities mature each month without having to invest their principal, removing liquidity from the financial system.

4. Currency volatility deepens

Another indicator that may make the Fed think twice is an increasingly volatile currency market. The dollar has been on fire this year, hitting multi-year highs against all major currencies and even pushing the euro below parity.

The Fed typically doesn’t watch the dollar appreciate, but an excessive depreciation of the euro could spark fears of deteriorating global financial stability. While the euro continued to depreciate earlier this month, the relative strength index (RSI) did not continue to decline, which may indicate that the euro’s decline has slowed, but it does not mean that the long-term downward trend line has been stopped.

EUR/USD spot trend. Source: Bloomberg
EUR/USD spot trend. Source: Bloomberg

John Vail, global chief strategist at Nikko Asset Management, said the Fed does not want to let the euro depreciate too much.

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